How much should we worry about the Chinese stock market collapse?

Jul 9, 2015

- By Vivek Kaul

Vivek Kaul
The Shanghai Stock Exchange Composite Index has fallen by 31.7% over course of the last one month. This after rising by 150% between July 2014 and early June 2015. Yesterday (July 8, 2015) it fell by 5.90% to close at 3507.19 points.

The Chinese government is desperately trying to ensure that the stock market does not fall any further. Yesterday, it banned share sales by major shareholders for a period of six months. This means that investors who hold greater than 5% stake in a company will not be able to sell any of their stake over the next six months. "This is not something would happen in the U.S. or in any other developed market...It does smell a little bit of desperation," Brian Jacobsen of Wells Fargo Funds Management told Bloomberg.

Other than this the government has already banned short selling. Initial public offerings by companies are also not being allowed, so that investors are interested in buying the shares already listed on the stock market. Over and above all this around 1,300 of the 2,800 stocks listed on the Shanghai Stock Exchange have announced trading halts.

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This massive fall has got the world worried. After all China is the second largest economy in the world. As a news-report on CNN.com points out: "Since China is the second largest trading partner for both Europe and the United States, it goes without saying that a healthy Chinese economy is good news for the developed world."

Further, China is a big consumer of commodities. If the Chinese economy slows down any further, its demand for commodities will fall. Taking this possibility into account, the West Texas Intermediary (WTI) oil price is down by 10% over the last one month. Similarly, copper prices have fallen by close to 7.5% during the same period.

The point being if the Chinese economy slows down, then the overall world economy will slow-down as well. This logic seems pretty straightforward. But the real story is a little more nuanced.

China was growing at double digit growth rates for a long time. Data from the World Bank shows, that the country grew by 10.6% in 2010. After 2010, the economic growth in China has been slowing down. In 2011, the economic growth was at 9.5% and since then it has fallen further. In 2014, the economic growth was at 7.4%.

The growth is expected to slip further this year, with the International Monetary Fund (IMF) projecting that China will grow by 6.8% in 2015. The economic growth projected for 2016 is 6.3%.

Even though the economic growth has fallen the Chinese stock market has gone from strength to strength. This has basically happened because of an era of easy money initiated by the Chinese government and the People's Bank of China, the Chinese central bank, in order to charge up economic growth.

The question is will the fall in the Chinese stock market create further woes for the Chinese economy? Conventional economic theory holds that a stock market ultimately should be a reflection of the state of the economy. But the state of the stock market also impacts the state of the economy.

As George Soros writes The New Paradigm for Financial Markets: "The crux of the theory of reflexivity is not so obvious, it asserts that market prices can influence the fundamentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals that they are supposed to reflect." Reflexivity refers to circular relationships between cause and effect.

One impact that I can clearly see is on Chinese companies which have high debt. A major reason behind the government propping up the stock market was to allow high-debt Chinese firms to have access to another source of funds. With IPOs now being banned that isn't going to happen.

The bigger question is how will the Chinese consumer react to this fall? Will his consumption of goods and services come down?

The Chinese exposure to the stock market is not very high unlike the Western countries. As Wei Yao of Societe Generale writes in a recent research report: "According to China Household Finance Survey (CHRS) conducted by the South-western University of Finance and Economics, equity market investment represented less than 10% of Chinese households' financial assets in 2013, whereas cash accounted for 17% and bank deposits accounted for nearly 55%. For reference, households' bank deposits are equivalent to 80% of GDP."

With the stock market rallying in the recent past before it started to fall, the number of households investing in equities has gone up. But Yao feels that the number still remains lower than 15%. The number is 34% in the US. Hence, not many Chinese households will be impacted by the fall in the stock market.

Typically, the wealth effect comes into play in a situation like this. With the overall consumer wealth coming down with the fall in the stock market, the consumer expenditure tends to come down as well.

Yao sees a limited possibility of that happening. "The Shanghai composite index peaked above 6,000 in October 2007 and subsequently lost half of its value by May 2008 and two-thirds of its value by November 2008. During the same period, real growth of retail sales first remained largely stable at 12-13% year on year and then picked up to 16-17% year on year thanks to disinflation," writes Yao.

She further points out: "When the equity market started to surge in March, we noticed that households were holding back on buying big-ticket items, especially cars. Passenger car sales growth fell precipitously from 9.4% year on year in March to 1.2% year on year in May. If the equity market were to crash, car sales might not pick up but might not deteriorate further either."

The Economist also puts across a similar sort of view: "The free-float value of Chinese markets-the amount available for trading-is just about a third of GDP, compared with more than 100% in developed economies. Less than 15% of household financial assets are invested in the stockmarket: which is why soaring shares did little to boost consumption and crashing prices will do little to hurt it."

What this tells us clearly is that we need to worry about the Chinese stock market crash, at the same time, we don't need to worry too much about it. The stock market is basically catching up with the economy.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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1 Responses to "How much should we worry about the Chinese stock market collapse?"

Lakshminarayanan

Jul 9, 2015

"This is not something would happen in the U.S. or in any other developed market...It does smell a little bit of desperation," Brian Jacobsen of Wells Fargo Funds Management told Bloomberg.

This self-righteousness attitude is what gets my goat. The same developed countries threw away mark-to-market when it suited them. They ban short-sellers when it suits them. Their Fed members come out in droves if the market falls 0.1%. Before being sanctimonious, Brian Jacobsen would do well to see what happened in his backyard. The guys in developed countries would do these things if it suited them. It is as simple as that.

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